November 29, 2000

November 29, 2000 | Commentary on Taxes

Big Brother or Financial Privacy?

A federal judge in Miami recently gave the Internal Revenue Service a green light to seize credit-card records from several Caribbean banks. This wholesale invasion of financial privacy is justified, the IRS says, because some American taxpayers may have set up offshore accounts to evade taxes.

The ruling has sparked a big debate. On one side are tax collectors and politicians who feel the agency must be able to collect all the information it needs to ensure that everyone is playing by the rules. On the other side are privacy advocates and foreign policy experts. The privacy advocates don't want to give government carte blanche to rummage through financial records. The foreign policy experts worry that we'll create a bad precedent-one that could be used against America in the future-by trying to impose U.S. law on banks chartered in other countries.

In other words, it appears we're facing a no-win situation. If the IRS doesn't go after tax evaders, those of us who obey the tax laws (or at least try) will feel like fools because we know that others are successfully hiding their money from the government. Yet few Americans want to sacrifice personal privacy and risk national sovereignty just so politicians can get more money to spend.

Fortunately, there is a solution. If lawmakers make a few modest revisions to the tax laws, we can have the best of both worlds-less evasion and more privacy. How? Consider a hypothetical tax evader. He has an account overseas, and he uses the money in that account to buy bonds from a U.S. corporation. The corporation isn't required under current law to withhold taxes on the interest it pays to him or other bondholders. Instead, the bondholders must report that income and pay the requisite taxes.

This system works reasonably well, particularly since most bondholders know that the corporation reports to the IRS how much interest they pay. But the system functions poorly when interest payments are sent to bondholders in other countries. Foreigners generally aren't required to pay tax on U.S. interest income, and American taxpayers posing as foreigners can use that special preference to dodge the tax man.

But what if we changed the law to require corporations to withhold and pay taxes on behalf of bondholders? All interest income thus would be taxed before it was sent to the individual bondholders, meaning it wouldn't be necessary for the IRS to monitor individual tax returns to see if that income was reported.

As a result, the tax evader can no longer evade. Yes, he can keep his Caribbean account, but the interest he receives will be an after-tax payment.

This analysis also works for dividend income. Under current law, corporate income is taxed at both the business and individual level. This is a policy that should be fixed regardless of whether there is tax evasion. But when it is fixed, we should remove the second layer of tax at the individual level. That way, we will make it impossible to evade taxes. It won't matter where the dividend is sent-Kansas, Bermuda, Japan, South Carolina or the Marshall Islands-since the taxes will have been withheld by the corporation.

In addition to reducing tax evasion, this would make our tax code simpler. Many large corporations have more than 1 million stockholders and bondholders. If we withhold taxes on dividend and interest income, there is only one tax return to worry about: the corporation's. The IRS won't have to track down millions of individual tax returns to see if that income is being reported, and businesses would be spared the cost and aggravation of mailing out more than 1 billion "1099" tax forms every year.

Consider the alternatives. If we don't fix our tax code, we'll have to endure either increasing levels of tax evasion or a greater loss of individual privacy. In an attempt to stop the former, the IRS is pushing new "QI" regulations designed to find U.S. taxpayers hiding money offshore by forcing foreign financial institutions to become informers.

But is this a good idea? Not according to Andrew Quinlan of the Washington-based Center for Freedom and Prosperity. "The IRS is trying to kill a fly with a sledgehammer," he says. "These costly and intrusive new regulations will drive away foreign investment and harm our economy."

Withholding is a better approach. The IRS gets its share, and people can protect their privacy. But this will only happen if the tax laws are simplified.

Daniel J. Mitchell, Ph.D.  is the McKenna senior fellow in political economy at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes

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